The IRS has released proposed regulations relating to the taxation of the income of foreign governments from investments in the United States under Section 892. Guidance under Section 892 was identified in the Obama administration’s 2010-2011 priority guidance plan and is intended not only to streamline the rules, but also to address problems and traps encountered by foreign governments with respect to the taxation of their U.S. investments. The proposed regulations, which taxpayers may rely on until final regulations are issued, will be effective until the date final regulations are published and supplement current temporary regulations in effect since 1988.


Under Section 892, income received by a foreign government from interest on bank deposits, as well as income from U.S. securities and certain financial instruments (“qualified investments”), are exempt from tax. Payments that do not qualify for exemption from tax include income derived from the conduct of a “commercial activity,” income received from a “controlled commercial entity” (including gain from the disposition of any interest in a “controlled commercial entity”) and income received by (directly or indirectly) a “controlled commercial entity.”

The Section 892 tax exemption is reserved only for “foreign governments,” which includes (i) an integral part of a foreign sovereign and (ii) certain entities controlled by the foreign government (a “controlled entity”). An integral part of a foreign sovereign that receives income from conducting commercial activities is still eligible to claim an exemption for income from qualified investments. However, a controlled entity that is engaged in “commercial activity,” regardless of how small or isolated, anywhere in the world, is treated as a “controlled commercial entity,” with the result that it will be taxable on all of its income under Section 892, including income not related to commercial activity.

A “controlled commercial entity” is an entity that is engaged in “commercial activities” within or without the United States if the government holds either (a) 50 percent or more of the total voting power or value of the ownership interests in the entity or (b) a sufficient interest (by value or voting power) that gives the foreign government effective practical control of the entity.

Proposed Regulations

The proposed regulations include several helpful modifications to the above rules including, among other items, 1) a deminimis exception pursuant to which an entity would not be treated as a “controlled commercial entity,” 2) clarification of the standard applicable for determining when an activity will be considered a commercial activity, 3) an expansion of two exceptions to activities that are treated as commercial activities and 4) the addition of an exception for certain limited partnership interests held by controlled entities. These modifications are summarized briefly below.

All or Nothing Rule

Under temporary regulations, the so-called “all or nothing” rule refers to the fact that a controlled entity that is engaged in any amount of “commercial activity” will be treated as a “controlled commercial entity” and all of its income will be taxable under Section 892. This rule is considered by foreign governments as unfairly punishing them for inadvertently conducting a small level of commercial activity. In response to this widespread criticism, the IRS proposed regulations that provide that an entity will not be considered engaged in commercial activities if it conducts only “inadvertent commercial activity,” although any income from such activity would not qualify for exemption from tax under Section 892. Inadvertent commercial activity refers, generally, to a controlled entity that “reasonably” fails to avoid conducting commercial activity, timely cures the conduct of such activity and maintains certain records. Whether a failure to avoid commercial activity is reasonable is determined under a facts and circumstances test. Consideration will be given to the relative number of commercial activities and the amount of income from and assets used in conducting commercial activities in relation to the entity’s total income and assets. Further, qualifying under the “reasonableness” standard requires continuing due diligence by the controlled entity. A safe harbor rule provides that entities that enact adequate written policies and procedures to monitor the entity’s worldwide activities may conclude that their failure to avoid conducting commercial activity is reasonable if the value of the assets held for use in the commercial activity is no more than five percent of the total value of all of the controlled entity’s assets, and the income earned from the commercial activity is no more than five percent of the entity’s gross income.

Definition of Commercial Activity

The temporary regulations provide, generally, that all activities, regardless of where conducted, if conducted with the view towards current or future production of income or gain, are commercial activities. Further, the temporary regulations exclude from commercial activities certain activities that involve investments in stocks, bonds and other securities, effecting trading transactions for a foreign government’s own account, cultural events, non-profit activities and governmental functions. The proposed regulations retain the general definition of a commercial activity, but clarify that only the nature of the activity rather than the purpose or motivation for conducting the activity is determinative. The proposed regulations also expand two of the exceptions from the definition of commercial activities: (i) U.S. investments in financial instruments, which will not be treated as a commercial activity irrespective of whether the instrument is held in execution of governmental financial or monetary policy; and (ii) trading of stock, securities and commodities, which will now include effecting transactions in financial instruments as well.


The temporary regulations provide that, except for partners of publicly traded partnerships, commercial activities of a partnership are attributable to its general and limited partners. The proposed regulations offer an expanded exception for controlled entities “not otherwise engaged in commercial activities.” Such entities will not be treated as engaged in a commercial activity solely because of holding an interest in a partnership (including a publicly-traded partnership) as a limited partner. An interest as a limited partner refers to an interest holder that does not have rights to participate in the management and conduct of the partnership’s business. The proposed regulations make clear, however, that a controlled entity partner’s share of partnership income attributable to any commercial activity of the partnership will be considered derived from the conduct of a commercial activity and, therefore, will not be exempt from tax under Section 892. Further, an entity “not otherwise engaged in commercial activities” will not be considered to be engaged in commercial activities solely because it is a member of a partnership that trades for its own account. However, this rule wouldn’t apply if the partnership is a dealer in stocks, bonds, other securities, commodities or financial instruments.

U.S. Real Property Interest

The proposed regulations add a new provision under the rules for commercial activities that makes clear that a disposition, including a deemed disposition under Section 897(h)(1) (relating to certain distributions by a qualified investment entity), of a U.S. real property interest, will not alone constitute the conduct of a commercial activity. Any income from such disposition, however, would not be exempt from tax under Section 892.

Annual Testing

The proposed rules provide for annual testing of whether an entity is a “controlled commercial entity.” Accordingly, an entity’s engagement in commercial activity in a prior taxable year will not be solely determinative of its status in a current year.

The proposed regulations provide welcome relief and a degree of certainty in a number of areas that have plagued foreign governments making investments in the United States.